Brian Fallow: Looser policy opens can of worms

Those inclined to wave away inflation as yesterday's problem need to remember how destructive it is.

The high dollar is causing real and lasting damage to manufacturers. Photo / NZ Herald

Listening to a procession of manufacturers say their piece to the parliamentary inquiry into manufacturing this week, two things were clear.

One is that the high dollar is causing real and lasting damage to their sector.

The other is that the idea that an overvalued exchange rate is the fault of the monetary policy framework has hardened into dogma.

Cast off outdated neoliberal doctrine. Change the Reserve Bank's mandate. Then New Zealand manufacturers will have a fighting chance. That was the message.

It echoes statements like this from Labour leader David Shearer last Sunday: "We'll make changes to monetary policy so that our job-creating businesses aren't undermined by our exchange rate."

It is glib. It glosses over difficult questions about what changes they have in mind, and what the costs, risks, trade-offs and spillover effects would be.

And it misdiagnoses the problem, which is that the rather enfeebled state of much of the other 99.8 per cent of the world economy has led to policies abroad which are unhelpful from New Zealand's point of view and which we can only hope succeed.

If the object of the exercise is to ensure that in the future the Reserve Bank runs monetary policy looser than it otherwise would, consider this: higher inflation would lower real wages, and real incomes more broadly, in the hope of protecting jobs in the favoured sector. Should the union movement support that?

Lower interest rates would increase the risk of a housing bubble that, this time, bursts messily all over us. Ask the Irish tradesmen flocking to Christchurch how much fun that is.

If it succeeds in making New Zealand exports cheaper to foreign buyers - a pretty big if - it will also make New Zealand assets cheaper to foreign buyers. That should give economic nationalists in New Zealand First and the Greens pause.

The Reserve Bank Act decrees that the objective of monetary policy is price stability.

This makes it easy to portray the central bank as being interested only in curbing inflation, willing to sacrifice swathes of the real economy in the process and being behind the times, stuck in some 1980s time warp still fighting yesterday's battle when "modern" monetary policy has moved on.

But that rests on an oversimplified view of what the bank, and its international peers, actually do.

What they do is try to minimise the output gap, that is, the gap between the economy's potential and actual output.

If it is negative (as it has been since the global financial crisis) the economy could be producing more, and employing more people, than it is.

Unemployment rises, businesses make less money than they might and governments have less revenue.

It is a waste and it requires the central bank to stimulate demand - normally by cutting interest rates but sometimes, in extreme circumstances when policy rates are at zero and it is still not enough, by quantitative easing.

At other times the output gap is positive. Demand outstrips the economy's capacity to supply. Spending and debt rise faster than incomes and incomes rise faster than productivity.

It is unsustainable and various ill effects follow.

Inflation is one of them.

Those who are inclined to airily wave that away as yesterday's problem need to remember how destructive inflation is; how hard it is, especially, on the poor and savers. New Zealand already has too much poverty and not enough saving. The last thing we need is to make those things worse.

Other ill effects of excess demand are likely to be sucking in more imports than can be paid for from export income, a temptation for the Government to spend up large in ways than can be difficult to reverse later, and for household saving to fall.

Faced with that, or the prospect of that, the central bank needs to tighten.

In both cases the aim is the same, to head towards balance between actual and potential or sustainable output.

Potential growth is driven by fundamentals like workforce and productivity growth; in those respects the central bankers have to take the world as they find it.

To sum all that up as a single-minded focus on inflation is simplistic.

The trouble is that potential growth and the output gap, while they may be central to the bank's thinking, are of no use for the purpose of accountability and communication. They cannot be directly measured, unlike the inflation rate or unemployment rate. They have to be inferred.

It is easier to measure the effects of monetary policy by the inflation rate or the unemployment rate, treating them as representative of the ill effects of excess demand or excess capacity as the case may be.

To subordinate all this to some other objective, like managing the exchange rate for the benefit of exporting manufacturers, would be a heavy sacrifice.

Put this to some of the chief executives at Monday's inquiry, and the response was: No, we don't want to mess with that. We just want to give the Reserve Bank an additional objective and additional tools.

Most likely that would be to intervene directly in the foreign exchange market, selling New Zealand dollars newly created for the purpose and buying US dollars or some other foreign currency.

The Reserve Bank already has a mandate to do just that, but it is heavily circumscribed.

Not only must the exchange rate be exceptionally and unjustifiably high, the bank must be confident intervention would work.

It will intervene "only when it assesses there is a material prospect of influencing the exchange rate". That is likely to be when it thinks a turning point is near.

And, crucially, it has to be consistent with the current stance of monetary policy.

It would be inconsistent, for example, to be reining in non-tradeable inflation through higher interest rates while stoking tradeable inflation through a lower exchange rate.

It would be inconsistent to try to hose down an overheating property market by making it more expensive for New Zealanders to buy, while making it cheaper for foreigners to do so.

It is not easy, in fact, to lower the international value of the Kiwi dollar without also lowering its value within New Zealand.

The bank can try, by sterilising the intervention - borrowing back the extra New Zealand dollars it creates to buy the foreign currency with. But that sticks the taxpayer with what could be, depending on the scale of the intervention, a hefty interest bill.

A year after the Swiss National Bank started intervening in September 2011 to defend an exchange rate of 1.20 Swiss francs to the euro it had expanded its foreign currency reserves to the equivalent of three-quarters of itsGDP.

An equivalent intervention in New Zealand would be $150 billion - a large bet to place with public money and a large sum to pay interest on.